The Future of Money Market Funds

6

It is rare to find an investment that is pertinent to ~99.99% of equity/REIT investors. There is one investment that is not widely discussed that probably IS pertinent to all investors and that is money market funds (MMF.) Even if your investment goal is to be 100% invested in equities/bonds/options or Tanzanian oil futures, you likely use MMF’s. Any time you deposit new funds, sell a holding or receive a dividend, the funds go into a MMF. Most of us take these for granted as a convenient parking place for cash with 0.00% risk. In the 2008 crash, one MMF (Reserve Primary Fund) “broke the buck” and was valued at 97 cents on the dollar. It was only the third MMF to break the buck and the first one since 1994.

The returns on MMF’s are about as close to 0.00% as you can get. Many MMF managers have to subsidize and/or waive management fees to keep the yields above zero.

There are two area of concern that I think investors should be aware of pertaining to MMF’s.

Point 1 is the concern that MMF’s will allow negative yields. This would mean that investors must pay the MMF for holding your funds. I have been hearing about this from more and more sources in the last few months. This week the "Report to the Secretary of the Treasury from the Treasury Borrowing Advisory Committee of the Securities Industry and Financial Markets Association" was released. They are EXPLICITLY recommending to the treasury that negative yields be allowed at treasury auctions.

Quote from the report:

There was a lengthy discussion regarding the bid-to-cover ratios at recent Treasury bill auctions. It was broadly agreed that flooring interest rates at zero, or capping issuance proceeds at par, was prohibiting proper market function. The Committee unanimously recommended that the Treasury Department allow for negative yield auction results as soon as logistically practical.

The Chair and Vice Chair of the committee are from JP Morgan and Goldman Sachs, so it is reasonable to think their recommendations carry substantial weight. I do not need to remind investors that what the TBTF want, the TBTF gets!

Even if the US Treasury does not allow negative yields at auctions, there is nothing that prevents MMF’s from going to negative yields. I think the issue is which MMF will break the ice. Nobody wants to be the first MMF to start it, but if one takes the jump, I would expect many more to follow.

While having slight negative yields is not very attractive for investors, it is NOT fatal IMO. Practically speaking there is not much difference between -0.1% yield and +.1%.

Point 2 is a lot more troubling. It is where MMF’s limit access to your funds. The goal is to prevent a run on the bank. (Where is Jimmy Stewart when you need him?) We all know that MMF’s only keep a few percent of the fund in 100% liquid cash on any given day. The rest of the funds are invested in bonds/notes/paper that mature in up to ~60 days. If investors attempted to redeem say 10% of the fund in a single day, it would not be possible. A potential run on MMF’s was such a large concern in 2008, the US Treasury came up with a program to guarantee all of the funds against breaking the buck. You don’t even want to think about what would happen if a MMF could NOT meet its redemption requests one day.

With this background, the MMF industry and government officials have been working on several alternate solutions to the run on the bank problem since 2008. They are taking it very seriously and IMO will implement something to try and prevent a run. The most common proposals being discussed are:

a) MMF has ongoing withdrawal restrictions 100% of the time. It might be in the form of “you can only remove X dollars per day” from the MMF.

b) MMF has automatically triggered restrictions based on market conditions. This could be based on stock market losses, treasury yields or some other metric that is easy to measure. If the alarm was triggered, you would be restricted on how many dollars per day you could redeem.

c) SEC is allowed to impose restrictions at their discretion. They would decide if MMF’s are allowed to limit redemptions.

d) MMF management is allowed to limit redemptions at their discretion.

e) Change the MMF business model to where the funds are NOT fixed at $1.00. If you had floating values, redemption would be easier to handle. For example in a ridiculously extreme case, you would only receive 50 cents for each “dollar” in the MMF if you redeemed during the middle of a run.

f) Add a separate “insurance fund fee” to the MMF structure, in order to build up a reserve fund. This is essentially what a lot of muni bonds do. They set up a rainy day fund in case something goes wrong on the revenue side. MMF’s would add a ~.05% fee. This would potentially help in the case of a run on the funds, but it could be swamped out by major requests.

The fund managers have a vested interest in implementing some plan before/if another crisis occurs. The various fed groups like the SEC/Treasury also have a vested interest in preventing future bank runs.

BOTTOM LINE is that changes are very likely to occur in MMF’s. My personal opinion is that we will see some MMF’s with negative yields in 2012. My opinion is that we will see some form(s) of redemption limits in the next year or two. I do not know which approach will prevail. The implication for investors is to think through what you would do if a redemption limit was implemented one day. Would you be able to keep functioning financially if this occurred? You might consider implementing a personal insurance policy for this low level risk. Maybe it is keeping more cash in a FDIC account. Maybe it is keeping more physical cash somewhere readily available, i.e. safe, safe deposit box, buried backyard next to the dog bones.

I decided to post this because MMF’s likely impact all investors and think it is worthwhile to think through the implications. If MMF’s limit redemptions it should be considered a “white swan” event, instead of a “black swan” event. (There is a “black swan” flying around that I am considering posting about.)